This article originally appeared on thinkingaboutmoney.com on June 20th, 2006.
One of the things I’ve learned in the past month is that diversification – the “holy grail” of investing, is not what it is cracked up to be. In fact, I’ve come to realize that one of my immediate investing goals should be to reduce the amount of diversification in my portfolio.
I realize that this statement will have many of you yelling and screaming, or immediately unsubscribing under the assumption I am a fool. But hear me out.
The idea of diversification is simple – it protects you from a serious loss in the event that a stock collapses. This is a real problem: I had a friend in college who was highly invested in a utility called “General Public Utilities”, dividends of which were helping pay for his college education. Unfortunately, this utility owned a nuclear power plant named “Three Mile Island”. Ouch! When the nuclear accident hit their stock crashed and my friend had some tough times.
The problem with diversification is equally simple. Once you are sufficiently diversified (say, through ownership of a selection of mutual funds), your portfolio will tend to reflect the overall market (typically underperforming it by a bit, if only because of the management fees). This means that when the market is good, your upside is typically limited to the overall behavior of the market, and when the market is down, your portfolio is pretty well guaranteed to lose value as the market declines.
Let me stress this: Most mutual fund based portfolios will decline when the market drops. Diversification through mutual funds provides no protection in down markets; rather, it virtually guaranteed losses.
In truth, diversification means two different things: protection from having all your eggs in one basket (so to speak), and matching the performance of the market. The former is obviously a good and necessary thing; the latter only good if you buy into the theory that the market will average a certain percentage gain over the long term and you should just buy and hold to get that return.
Let’s consider the first type of diversity. The overall market performance is based on a large set of companies, some of which rise dramatically in value, some of which become worthless, some of which hardly change in value, and many of which simply track overall market performance as investors add or remove money from the market following existing trends.
Let’s assume that by actually doing your homework – researching a company, reading their financial statement, and applying your own knowledge of the industry, that you can select stocks that can beat the overall market by 10%. That doesn’t mean they’ll always go up – just that if the market declines by 20%, you’re stocks will drop 10%. If the market goes up 20%, yours will go up 30%. Of course some of your choices may do better, and some worse, but let’s say you can average 10% better. Keep in mind that of that 10%, at least 1.5% and often more is “free” because you won’t be paying mutual fund management fees.
If your portfolio contains 15 stocks, one of them can become worthless and you will still beat the overall market.
So in truth, you don’t need multiple mutual funds containing dozens of stock to protect yourself from the collapse of one security. And if you learn to sell on time (see review of “Why Smart People Make Big Money Mistakes and How to Correct Them“), you wouldn’t even need to do that well.
Does that mean I’m recommending you go out, sell your mutual funds, and buy individual stocks?
NO – NO – NO!!!
Remember the name of this site: “Thinking About Money.” That means that you will never read simplistic advice, rules or guidelines here. The observations you read here are parts of a bigger picture intended to help me (and you) develop an overall financial strategy.
My point here is that there’s diversification as preached in the financial media, and there’s diversification in its true sense of preventing the loss of one asset from representing a financial disaster. My argument here depends on one being able to choose investments and manage them in a way that does better than the overall market. I believe this is possible, but I also believe it requires thought, discipline, research and strategy.